Exchange-traded funds are some of the best investment vehicles for investors looking for tax-efficiency.

Exchange-traded funds are some of the best investment vehicles for investors looking for tax-efficiency, according to CNBC.

Dave Nadig, chief investment officer and director of research at ETF Trends believes the unique structure of these investment vehicles is what drives investor demand for them. "It’s really pretty simple. When you think about it, you’re running a portfolio. You’re buying and selling stocks. That’s what you do. Or bonds, in this case. And in an ETF, when you acquire new securities, you don’t go buy them. You generally get them in a creation unit. The same thing happens when you get rid of securities. They go out in a redemption. And when you do that, you’re constantly resetting the basis of the fund. That means when they come to the end of the year, they haven’t realized any capital gains inside the fund that they have to pass out. Because of that, the vast majority of ETFs never make a capital gains distribution, particularly if they’re index-based. So, the gains that you’re going to have to pay are the ones when you decide to sell, which is just generally more fair. There’s no avoidance here; they’re simply deferring the tax event to when you as the investor make the decision. That’s why ETFs continue to have this tax advantage."

Nadig was then asked if there were other places investors needed to be careful and about his opinion on gold. "Yep. None of that’s changed. ETFs are generally taxed by the IRS based on what they own, so, if your fund just owns gold, you’re going to get taxed as if you just bought bullion, and that means no matter how long you hold it, you’re going to pay a 28% tax on that gain. It’s not short term, it’s not long term, it’s just the collectibles tax. The only other real place is some of the commodities funds that just own futures. That can be a little bit trickier at the end of the year. Some of those funds put out a K-1 that you’ll get a partnership statement and you’ll pay a blended 60-40 rate. If you’re getting into those kinds of funds, you probably need to be having somebody look at your taxes anyway."

Next, Nadig was asked how master limited partnership investments fit into this conversation. "MLPs have their own special treatment where they do return of capital, which can be really great for your taxes. You don’t even have to report that. It just resets your basis. But again, when you’re starting to get into slightly more tax-complicated vehicles like MLPs, like commodities, it’s probably a good time to get some advice. I will point out, though, that the ETF structure’s still the most effective way to own those kinds of investments."

For investors looking to own ETFs in a tax-deferred account such as a Roth IRA Nadig stated that "you’d lose that tax advantage because you simply don’t care. So, what I tend to tell people is if you’re going to do some sort of trading activity where you’re going to generate names on your own or if you’re going to own something like, say, an actively managed mutual fund that trades all the time that’s going to throw off capital gains, do that in your 401(k), do that in your IRA rollover. For your money that you’re keeping in a taxable account, keep that in ETFs."

Chief investment officer and director of research at ETF Trends, Dave Nadig, explained how ETFs can provide significant tax advantages for investors.

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Economics, Finance and Investing